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Paulson's Land Grab: Will Your Bank Be Next?

Not all banks deserve the Treasury's largesse.

I woke up this morning to find out that the federal government had appropriated for itself partial ownership of a bank -- Wells Fargo(NYSE:WFC) -- of which I am a shareholder through the Treasury's plan to make direct investments in some of the country's largest banks. That's disconcerting, because some of the banks in question didn't need a government-funded capital infusion.

And the winners are …The group includes the largest companies in each banking subsector, from universal banks such as JPMorgan Chase(NYSE:JPM), Bank of America(NYSE:BAC), and Citigroup, to investment-turned-commercial banks Goldman Sachs and Morgan Stanley, and custodian banks such as State Street(NYSE:STT), and Bank of New York Mellon(NYSE:BK).

(That last category of banks has not received much attention during the current crisis, but they are a vital part of the financial system's plumbing because they track and hold assets, primarily bonds and equities on behalf of institutional investors. The largest global custodian, Bank of New York Mellon, has a mammoth $23 trillion of assets under custody or administration.)

Don't misunderstand me -- I think it makes a lot of sense for the Treasury to make equity investments in U.S. banks at this time. The magnifying effect of leverage means an equity investment wields greater impact than simply removing troubled assets from bank balance sheets. It had become clear that the banking sector as a whole was undercapitalized.

My concern is whether size should be the Treasury's governing criterion in choosing investment targets. Not all the institutions on its list are in a precarious position -- far from it. Could well-run banks like BB&T(NYSE:BBT) and US Bancorp(NYSE:USB) be part of the second round?

Size mattersTargeting only the largest organizations in each segment is high theater on Hank Paulson's part; perhaps that's what is required to restore investor confidence and avoid a complete breakdown of the banking system. The short-term effect is clear; as I write this, the KBW Bank Index is up more than 11% today.

The move could have insidious longer-term effects, though, as it strengthens the "too big to fail" doctrine of bank regulation (which largely contributed to this debacle) and penalizes the better-run organizations for the mistakes of their incautious peers.

All banks aren't created equal. Perhaps it's no coincidence that three banks that are riding out the crisis better than their peers -- JPMorgan Chase, BB&T, and US Bancorp -- have been Motley Fool Income Investorrecommendations since well before the crisis began. To find out the latest recommendations, take a 30-day free trial today.